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Reengineering My Portfolio Management, Part IV: The Asset Allocation In Percentages

Contributed by mm | February 18, 2007 4:02 PM PST

The exact percentage one should devote to each asset class is something that will and should change over time based on one's updated assessment of relative attractiveness of each class. Wall Street portfolio strategists constantly change the recommended mix between equity, bond and cash, and I expect to do the same on a not-to-infrequent basis -- I'm thinking abut revisiting the asset allocation decision quarterly or semi-annually now.

Here is my current exposure in each of the four asset classes (as of January 31, 2007):

Domestic Equity: 38%
Foreign Equity: 25%
Cash & Fixed Income: 27%
MSFT Stock Option: 10%

I have to admit the above distribution is not coming from conscious management -- I did a lousy job in the past to care about the allocation, so the above distribution is mostly the legacy from years of investing in what I see fit. Moving forward, I will be more disciplined to manage the distribution, though.

When I think of making trade-offs between these asset classes today, some relevant observations are:

1) MSFT Stock Option will definitely be the most volatile asset class, and potentially the most rewarding one. It only takes a 10% uplift in MSFT stock price to increase the value of my stock options by 50% (and conversely, 10% drop in MSFT stock price = 50% stock option value wiped out). While my risk tolerance is relatively high, the currently 10% concentration in this asset class is still a bit too much for me.

2) Out of the remaining four classes, foreign equity is likely to be the best performing asset class over time, followed by domestic equity, fixed income and cash. I have some good success in investing in international equity mutual funds (hindsight view?), and do believe given the continued globalization, foreign market will grow faster than domestic U.S. market. Plus, Warren Buffett shared the wisdom that foreign equity plays bring the extra benefit of hedging against a declining dollar. Therefore, I look forward to expanding my exposure in international stocks.

3) While I don't have too many clues about how the U.S. stock market will perform in the near future -- the economy is heading toward a slowdown and the current bull market has been running too long without a material correction -- I do plan to put more money in the Domestic Equity class than any other class since I have intimate knowledge of the market and given the depth of the market, I do believe enough value opportunities will pop up, allowing a decent return regardless of market climate.

4) The conventional wisdom for a portfolio with a long time horizon is to minimize the cash holdings, but I do intend to keep a somehow outsized cash cushion for now - the current 5% risk-free return on most high-yield money market funds is yummy, and the added liquidity is certainly a plus should we choose to make a real estate investment in the next few years.

Here is my current target allocation across the four asset classes:

Domestic Equity: 45% (+7% from now)
Foreign Equity: 35% (+10% from now)
Cash & Fixed Income: 15% (-12% from now)
MSFT Stock Option: 5% (-5% from now)

Next: How should I construct my portfolio to achieve the desired asset allocation?

This Post Has Received 35 Comments. Share Your Opinions Too.

CPA1298 Commented on February 18, 2007

I'm so glad to see you're beginning to analyze your allocation. There's a school of thought (to which I subscribe) that your allocation, and the courage to stick with it, will be one of the largest determinants of how your portfolio performs over time.

Nagel Commented on February 19, 2007

Diversification is essential to great returns, however, being inflexible can be problematic as well. Here is some more on diversification through mutual funds:

soulek1 Commented on February 20, 2007


Cool website. Why did you leave out:

1) Currencies
2) Commodities

as asset classes?

Are you planning on hedging the currency risk somehow (i.e. dollar decline of 30% over coming five years relative to yuan)?

Do you think current commodity craze (gold, oil, crops, etc.) is fad?

Best regards,


MM Commented on February 20, 2007

Soulek1, if I still haven't made myself clear on my position of currency plays, what I believe is:

1) I'm not and won't be knowledge enough to make money in trading currency.

2) If Warran Buffett is wiser than me, his lesson is to invest in foreign equity to hedge a declining dollar.

The apprecation Yuan vs USD is mostly a weakening dollar instead of a stronger yuan -- Yuan actually depreciated against Euro and JPY last year.

joewatch Commented on February 26, 2007

I don't think you should be including your stock options in your asset allocation model, because the amount "allocated" to stock options will not need to be rebalanced. The proper way to deal with stock options is to wait until right before the time they expire, then exercise and sell the stock immediately.
Stock options should be treated as income, not investments.

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